Cost of Capital

What is it?

The Cost of Capital of a business is the minimum return that investors require in order to compensate them for the risk they take on in investment. The business has to at least earn this or destroy value.

When is it useful?

The cost of capital plays a key role in the business because it represents a hurdle rate – any investments must at least return the cost of capital or they should be rejected.

Except for the biggest investments – e.g acquisitions – it is rarely helpful to over-analyse the cost of capital. Most businesses could pick a real return of 8% or 10% and then focus all their debate on the business drivers and risks rather than be more sophisticated.

An Example?

How do you do the analysis?

Financiers use a CAPM formula (Capital Asset Pricing Model) to calculate the cost of capital (sometimes called the Weighted Average Cost of Capital (WACC). This is because it is calculated from a weighted average of the Cost of Debt and the Cost of Equity multiplied by the gearing ratio.